The Fed wants to keep the inflation rate up around 2%, simply because their efforts to boost the economy only get traction when they can push interest rates well below the inflation rate — something that's tough to do when the inflation rate is as low as it's been.

Normally, it's no problem to produce inflation: The Fed just creates some additional bank reserves. The banks respond by lending more money to businesses and consumers — who spend the money. That extra money out in the economy buying stuff is inflation. Rising prices follow directly (unless production is growing even faster than the money supply).

Just lately, though, the Fed has been stuck. A lot of businesses and consumers can't borrow, because they can barely service their existing debt. The ones who could borrow don't want to. And many banks have a balance sheet that's too shaky to support much lending, even if they can find a customer who's both willing to borrow and able to pay the debt back. The extra bank reserves just sit there.

But it's looking like the Fed has found a channel to produce the effect it wants: the exchange rate.

You can see in the graph above the two recent dollar lows — one in the early days of the recession and then another in the early days of the recovery. Just lately the dollar has been plummeting again. That's inflation too. In fact it is the very definition of inflation, which is the money becoming less valuable. (Rising prices are merely the symptom.)

Weakening the Dollar

Normally, the Fed (and the Treasury) like a strong dollar. It's good for consumers — a strong dollar means that imports are cheap. It's also good for most businesses. Exporters don't like it, because a strong dollar makes their goods less competitive overseas. But because the US imports so much of its fuel, a strong dollar is a win even for many businesses that export a lot of what they produce.

At the moment, though, the stars have aligned such that there's a lot of support for a lower dollar. That gives the Fed the opportunity to produce the inflation it wants — by weakening the dollar overseas.

Fed officials have been talking about "additional accommodation" and "further purchases of longer-term Treasury securities" for some time, and the minutes of the most recent Fed meeting show that they've been thinking about it for weeks. Judging from the hints so far, it looks like the Fed is going to buy a few hundred billion dollars of longer-term Treasury securities over the next few months. That will produce some inflation in the usual way (even though, as described above, that channel is mostly blocked). It will also push down longer-term rates, which has the knock-on effect of making the dollar less attractive to investors who want to hold bonds. That may make a few businesses and consumers a little more able and willing to borrow and spend. It also makes it less attractive for foreign holders of bonds to hold bonds in US dollars. (That's why the dollar has been dropping so fast just lately.)

And it's that falling dollar that's the real channel for this effort to have its effect. A less-valuable dollar is exactly what the Fed is trying to produce. That will lead to rising prices (initially for imports, but very soon for everything). Normally, its most immediate effect — rising prices for oil and other commodities — would make any effort to push down the dollar too unpopular to consider. But, just at the moment, there's something of a political consensus that we need to to push the dollar down. (Mainly, there's a general sense that we need to push the dollar down against the Chinese yuan, but that's very hard to do directly. However, it's very easy to push the dollar down in general. Then it will be somebody else's problem to get the details right as far as relative changes versus the yen and the euro and the Canadian dollar.)

What it Means, What to Do

It's pretty tough for Americans to protect themselves against a falling dollar.

Shifting some of your savings into some foreign currency is an option, but that's fraught for several reasons.

It negates the one big advantage of holding cash, which is that you can always use it to pay your bills. (I know exactly how many dollars I need to pay my rent from now until my lease runs out. I can only guess how many euros I'd need.)

It exposes you to exchange-rate risk. (If the dollar recovers sharply, you could lose a lot of money.)

It exposes you to other risks that you're probably not adequately familiar with — foreign institutions that might be credit risks and foreign legal systems that might or might not protect your interests — and to costs that might be significant compared to your investment return.

For most people, though, the loss of value in your savings is insignificant compared to the lost of value in your income (which is probably almost entirely in dollars). The only real way to fix that is to get some additional income in euros or yen or yuan — but that's not practical for most Americans.

If you're not an American, you're stuck facing the flip-side of this. Your currency is strengthening, which is great to the extent that imports will be cheaper, but bad to the extent that your (and your neighbor's) livelihoods depend on selling things to Americans.

There are two bright sides to this.

First, a falling exchange rate usually translates into rising prices only gradually. That's not true of commodities like oil, but for other goods, the manufacturers, importers, and retailers usually take most of the loss, at least for a while — in order to keep their market share and maintain good relations with their own suppliers and customers. So, expect the price of consumer goods to lag changes in exchange rates.

Second, for the reasons described above, the Fed isn't completely insane for wanting this. Rising inflation will let the Fed's policy moves gain some traction. A weaker dollar will boost U.S. manufactures. A recovery in the U.S. economy will yield benefits to everyone.

I don't think those benefits will exceed our losses, but they do exist.

After diversifying your income internationally (always hard to do, but worth attempting), your next best move (for Americans) is to find ways to reduce purchases of imported goods. Just using less is always a good idea — the less fuel you burn, the less you have to buy with your weaker dollars. Where you can't (or don't want to) reduce your consumption, source as much of what you buy locally as possible.

And, since those are all good things to do anyway, you can understand why producing a falling dollar isn't a mistake this time. They're doing it on purpose.

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Susannah #1

What are some ways I can diversify internationally? I'm planning a move to the UK next fall for graduate school and expect to pay my way through a combination of savings and a loan (total for year: about 20,000-22,000 pounds). I've already lived in France during one of the worst exchange rates since the adoption of the euro so I'm expecting the worst, but this news is truly disheartening. Any advice?

If you're actually in a foreign country, earning money in a foreign currency isn't much different than earning money in your own currency when you're at home. You have the usual choices:

1) Interest and dividends. You can put your money in a UK bank and earn interest, or you could invest in the stock of UK companies that pay dividends in pounds. (If you're borrowing money, this is probably not a way to come out ahead.)

2) Employment. In the US, I think a student visa would permit you to work on campus as a teaching assistant or research assistant, and may permit some other kinds of work as well. I have no idea what the law is in the UK.

3) Non-employment work. Even if your visa doesn't permit you to take a job, you might be able to do other kinds of work. (Maybe you could knit and sell sweaters. Maybe you could write articles for UK magazines on a freelance basis. Maybe you could tutor undergrads in whatever your field is.)

In any case, it isn't the means of earning the money that's different, it's just who's paying you the money (because that usually determines what currency they're going to pay in).

You're right—and I didn't say it was a good idea, just that it had a bright side.

"Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose." — John Maynard Keynes

Hard money types always like that quote. It's great to see Keynes and Lenin agreeing, for one thing, and it's great to see someone who's work has been used to justify inflation pointing out the harm it does so clearly.

But there's a fundamental question of the nature of money: is money like a promise, or is money like a price? If it's a promise, then it shouldn't be broken willy-nilly. But if it's a price, then adjustments are perfectly reasonable. (And, of course, even promises are sometimes broken.)

"But there's a fundamental question of the nature of money: is money like a promise, or is money like a price? If it's a promise, then it shouldn't be broken willy-nilly. But if it's a price, then adjustments are perfectly reasonable. (And, of course, even promises are sometimes broken.)"

That's a reasonable question. Certainly with the currencies of today, money is like a price. The trouble is, I am not sure that the average person knows this. I feel that the general perception is of money as a promise. I think this perception explains the panicking and general instability that occurs in the modern economy. People are reacting to what feels to them like a broken promise.

I've been watching this stuff happen for a long time now. I wasn't around when the government seized all the private gold back in 1933, but I do remember when Nixon closed the gold window in 1971—basically seizing all the public gold. (If he hadn't done so, all of our gold would have ended up in the hands of the French.)

Until 1971, foreign exchange rates were technically fixed—the dollar fixed to gold, all other currencies fixed to the dollar—although they did change from time to time. (Changes were a big deal.) After 1971, with the dollar fixed to nothing, it became steadily more difficult to maintain those parities. (Changes became steadily more common.)

In my mind, the transition was pretty much complete in 1981. In that year my economics professor in a Money and Banking course said, "floating exchange rates work." The transition from money-as-promise ($1 = 13.7 grains of gold) to money-as-price ($1 = whatever it buys in the market) was complete.

But you're right—a lot of people still feel like money is a promise. And that makes sense. Money ought to serve as a standard. It shouldn't make any more sense to devalue the dollar than it would make to devalue the yard or the gallon. (As of tomorrow, the gallon will be 121.65 fluid ounces....)

But shifting exchange rates turn out to be a very good way to adjust to economic realities. Imagine if China had not been manipulating the value of the yuan all this time. If its value had drifted up as the Chinese economy grew, many of the problems we're dealing with now would have been avoided. A lot of production would still have moved to China in search of cheap labor, but not as much, because the labor would have grown more expensive a bit more quickly. At the same time, Chinese workers would have been paid in a currency that was growing in value, increasing their access to foreign products. They probably wouldn't have imported a lot more, but they've have imported some more stuff from overseas, easing the trade surplus.

There'd still have been imbalances, but they'd be relatively minor—something that could be worked out. Instead, we've got this current mess.

"But shifting exchange rates turn out to be a very good way to adjust to economic realities. Imagine if China had not been manipulating the value of the yuan all this time. If its value had drifted up as the Chinese economy grew, many of the problems we're dealing with now would have been avoided. A lot of production would still have moved to China in search of cheap labor, but not as much, because the labor would have grown more expensive a bit more quickly. At the same time, Chinese workers would have been paid in a currency that was growing in value, increasing their access to foreign products. They probably wouldn't have imported a lot more, but they've have imported some more stuff from overseas, easing the trade surplus."

To me, it all comes down to a sense of justice and fairness that I admit may be outdated in modernity (or is this post-modernity, or post-post?).

The people of China have been working against a purposefully weakened yuan, and so, as you said, they have been unable to reap the rewards of their labor (access to imported goods, among other things). This made Chinese factory workers virtual servants of western consumers (I hesitate to use the word "slave" but I feel I almost could).

Speaking broadly, it seems like currency devaluation always hurts the lower echelons of society. Rich guys become richer guys. The lower casts are unable to save money or purchase goods in the same way they would be able to otherwise. I don't like the idea of the elites of our world being able to rob the workers without the workers ever knowing how it happened. Then again, I am one of those hard currency guys. :)

You're absolutely right that the Chinese workers got screwed out of the value of their labor. Much of the value accrued to Americans, who were able to buy more cheap crap with their overvalued dollars.

I actually have rather more inclination toward the "money is a promise" point of view, than might have been obvious if you read just this one post. You might be interested in some of my other posts on inflation (I linked to one in the main post.)

You might also be interested in my post Wage Slave, Debt Slave, which touches on some of the issues you're alluding to.

"I actually have rather more inclination toward the "money is a promise" point of view, than might have been obvious if you read just this one post. You might be interested in some of my other posts on inflation (I linked to one in the main post.)"

I'm with ya. I get really bothered by the' "sticky on the downside" argument regarding wages as a justification for inflation (referring to your other post). It seems a lot like they are saying something akin to, "In the case of deflation, regular people make way too much of what should be our money. We have to expand the money supply to correct this."

A buddy of mine has put together a little slideshow regarding inflation and the effects it has on economies and regular people. It might come off as a little sensational at first, but I think he is right on the money (er, I mean fiat currency) with it. It is at matt.com if you are interested in checking it out.

"It's pretty tough for Americans to protect themselves against a falling dollar."

Unfortunately... one factor driving the purchasing power of the dollar down... is the world fact... that China has the educational infrastructure, the population and our exported factory base... as the economists call it... 'the towering heights' to change the balance of money in the world.

The history of the world, from the Silk Road, to the demise of the Spanish Armada, shows that any nation, that loses it's edge, politically, economically, from within or without... will suffer a decline.

Our decline has just been hastened by our shortsightedness, our belief in short term profit over long term gain. Paying huge bonuses to people who have produced nothing ... but pain and suffering.